ATO spotlight on professional firm profits
Written By Kathleen Jess
Following the recent Senate inquiry into professional firms’ standards of ethical conduct, the ATO has renewed its focus on income splitting arrangements of owners of professional firms. Owners (traditionally partners) of professional firms have been known to redirect their ownership interest (and therefore their income from their professional services) to an individual or associated entity, significantly reducing their personal tax liability as a result. These arrangements are commonly referred to as Everett Assignments. In recent years, the ATO has become increasingly concerned with the risk that income earned by professional firms is not appropriately taxed to the individuals providing the services to the firms.
Practical Compliance Guideline 2021/4 (the Guideline), effective from 1 July 2022, outlines the ATO’s approach to ensuring compliance regarding the distribution of profits or income from professional firms in the assessable income of its individual professional practitioners (IPPs). The Guideline also serves as a guide for IPPs to assess the risk of their arrangements and anticipate the ATO’s compliance treatment.
What is a professional firm and who is an IPP?
The Guideline defines professional firms as entities that provide tailored, knowledge-based services across various professions, such as accounting, architecture, engineering, financial services, law, medicine, and management consulting.
An IPP is an individual who is a member of a recognised profession with a legal or beneficial stake in the professional firm, offering services either to the firm’s clients or the firm itself.
When can an IPP use the Guideline to assess the risk of their arrangement?
An IPP is only eligible to use the Guideline to assess the risk of their arrangement once the following criteria are satisfied:
- the IPP provides professional services to clients of the firm or is actively involved in the management of the firm, and the IPP and/or associated entities have a legal or beneficial interest in the firm;
- the income of the firm is not subject to the personal service income (PSI) rules;
- the firm operates by way of a legally effective structure (i.e. partnership, trust and/or company);
- the IPP is an equity holder, directly or through an associated entity; and
- it has been assessed that the arrangement is both commercial and does not have high-risk features (referred to as the ‘’).
Gateway 1 – commercial rationale
In order to satisfy this Gateway there must be a genuine commercial basis for the arrangement and also for the way in which profits are distributed. It should be noted that the mere assertion that the arrangement has a commercial rationale will not satisfy this requirement. The arrangement must have a genuine commercial rationale which the arrangement achieves.
An arrangement that has a commercial rationale should reflect the commercial needs of the business, for example, the arrangement is likely to enhance, assist or improve the business’ ability to produce income or make profits.
Indicators that suggest an arrangement does not have a commercial rationale include:
- the arrangement seems more complex than is necessary to achieve the relevant commercial objective;
- the arrangement includes a step, or a series of steps, that appear to serve no real purpose other than to gain a tax advantage;
- the tax result of the arrangement appears at odds with its commercial or economic result;
- the arrangement results in little or no risk in circumstances where significant risks would normally be expected;
- the parties to the arrangement are operating on non-commercial terms or in a non-arm’s length manner; and / or
- there is a gap between the substance of what is being achieved under the arrangement (or any part of it) and the legal form it takes.
Gateway 2 – high-risk features
In order for an IPP to rely on the Guideline, they must also satisfy this gateway in that the arrangement must not have certain high-risk features, including:
- arrangements covered by a Taxpayer Alert;
- exploitation of the difference between accounting standards and tax law;
- the arrangement purports to admit an individual who is not an owner or equity holder in the partnership as a partner of the partnership;
- a partner’s relationship with the partnership has characteristics indicating that relationship is akin to a contractor or employee of the partnership; and / or
- multiple classes of shares and units held by non-equity holders.
What if Gateway 1 and Gateway 2 are not satisfied?
Failure to satisfy the Gateways mentioned above will result in the arrangement being considered high risk. In such circumstances, the IPP would be expected to engage with the ATO, who would likely undertake a review or audit of the arrangement and the parties thereto.
Applying the risk assessment framework
If Gateways 1 and 2 are satisfied, the Guideline provides a compliance approach for IPPs to self-assess the expected level of risk with which the ATO will treat the arrangement.
Step 1: Determine the aggregate risk assessment score of the arrangement
The following table sets out each risk assessment factor to be considered and the correlating score. The aggregate score is calculated from the combined score of the first two risk assessment factors or the combined score of all three factors. The use of the third risk assessment factor is optional due to the difficulty of making an accurate assessment.
| Risk assessment factor | Score | |||||
| 1 | 2 | 3 | 4 | 5 | 6 | |
| (1) Proportion of profit entitlement from the whole of firm group returned in the hands of the IPP | More than 90% | More than 75% to 90%, inclusive | More than 60% to 75%, inclusive | 50% or more to 60%, inclusive | More than 25% to less than 50% | 25% or less |
| (2) Total effective tax rate for income received from the firm by the IPP and associated entities | More than 40% | More than 35% to 40%, inclusive | 30% or more to 35%, inclusive | More than 25% to less than 30% | More than 20% to 25%, inclusive | 20% or less |
| (3) Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm | More than 200% | More than 150% to 200%, inclusive | More than 100% to150%, inclusive | More than 90% to 100%, inclusive | More than 70% to 90%, inclusive | 70% or less |
Step 2: Determine the risk level of the arrangement.
Once the aggregate score has been calculated, the IPP can check the score against the below table to determine the arrangement’s risk zone.
| Risk zone | Risk level | Aggregate score against first two factors | Aggregate of all three factors |
| Green | Low risk | 7 or less | 10 or less |
| Amber | Moderate risk | 8 | 11 and 12 |
| Red | High risk | 9 or more | 13 or more |
Step 3: Determine the expected compliance response from the ATO
The type of compliance attention that the ATO will give to the arrangement is determined by the risk zone of the relevant arrangement.
| Risk zone | ATO Response |
| Green | An aggregate score within this zone indicates a low-risk arrangement. The ATO will only apply compliance resources to review the allocation of profit in exceptional circumstances (e.g. concerns that the self-assessment is incorrect, or not adequately supported by evidence). |
| Amber | An aggregate score within this zone indicates a moderate risk arrangement. The ATO will likely conduct further analysis on the facts and circumstances of the arrangement. |
| Red | An aggregate score within this zone indicates a high-risk arrangement. The ATO will likely conduct further analysis on the facts and circumstances of the arrangement as a matter of priority. If the ATO confirms that the arrangement is high risk following its analysis, it may audit the firm. |
It should be noted that the ATO may fact-check the self-assessment of a professional firm’s profit allocation. In such circumstances, if the IPP is unable to provide evidence to support their assessment, the ATO may undertake further compliance activity in relation to the arrangement.
Need further advice?
If your client is an IPP of a professional firm and requires advice on entering into new arrangements or assessing the risk of any existing arrangements, please contact or refer your clients to Kathleen Jess on (03) 9612 7212.
